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Capital adjustment cost and bias in income based dynamic panel models with fixed effects.

Abstract

The fixed effects (FE) estimator of "conditional convergence" in income based dynamic panel models could be biased downward when capitaladjustment cost is present. Such a capital adjustment cost means a rising marginal cost of investment which could slow downthe convergence. The standard FE regression fails to take into account of this capitaladjustment cost and thus it could overestimate the rate of convergence. Using a Ramseymodel with long-run adjustment cost of capital, we characterize this bias that does not goaway even for a longer time dimension. The size of the bias is greater in economies witha higher adjustment cost. The cross-country regression suggests that the size of this bias could be substantial.